This page discusses the impact of historical changes in the spread
between the Prime Lending Rate and LIBOR index on the cost of private
student loans. It argues that private student loans which are pegged
to the LIBOR index are better than those pegged to the Prime Lending
Rate, all else being equal, since the spread between the Prime Lending
Rate and LIBOR index has been growing over time.

The interest rates on variable rate private student loans are usually
specified as the sum of a base rate (also called an index) that
varies, plus a margin that does not. About half of private
education lenders offer variable rate private student loans that are
pegged to the LIBOR index, about 2/5 to the Prime Lending Rate, and
the rest to the 91-day T-bill.

Advertisement

Definitions

LIBOR is an acronym for the London Interbank Offered Rate, and is
also known as Eurodollar deposits. It is the average interest rate
paid on deposits of US dollars in the London market. It is the
interest rate at which lenders can borrow money from other banks. As
such, it measures the cost of capital for a bank. Private student
loans typically are based on either a 1-month or 3-month average of
the LIBOR index.

PRIME is the Prime Lending Rate as published in the Wall Street
Journal. This is the rate banks charge their most creditworthy
customers. It is commonly used in setting the interest rates on credit
cards.

91-day T-bill is the 3-month US Treasury Bill. This is the cost to
the federal government to borrow money.

The spread between two indices is the difference between
the interest rates.

Cost of Capital

Lenders earn revenue by borrowing money at one rate (the cost of
capital) and lending it at another, higher interest rate.

When a bank offers private student loans, it obtains the money it
lends from one of four sources:

Customer deposits.

Capital raised by selling stock.

Credit-warehousing facilities. These are loans from large
international banks.

Asset-backed securitization (ABS). This involves transferring the
loans to a trust and selling shares in the trust to investors. The
lender recovers the initial loan capital plus a premium. The lender
may also receive deferred revenue from servicing fees and advisory fees.

Lenders start off using a credit warehousing facility as an initial
and short-term source of funds, and securitize the loans when they
have accumulated enough volume. Typically one needs at least $100
million in loans to securitize ($1 billion is more common).

Lenders prefer securitization over credit warehousing facilities
because the cost of capital is usually lower. Both credit warehousing
facilities and securitization involve paying interest at rates pegged
to the LIBOR index, but the margins on credit warehousing facilities
are often higher.

Lenders also prefer securitization because it gives them a portion of
their profits up front in the form of the premium. Lender
profitability depends on how quickly they can securitize their debt,
since this reduces reliance on higher-cost credit warehousing
facilities.

Since the interest rates on securitizations are pegged to the LIBOR
index, many lenders prefer to peg interest rates on
private student loans to the same index. It yields a more
predictable profit margin. (Likewise, since securitizations assign
different margins to different credit tranches, lenders have an
incentive to vary interest rates according to credit risk.) If they
peg the loan rates to the Prime Lending Rate, it can lead to "basis
risk" and require the lender to employ interest rate swaps and hedging
to limit the risk that the Prime Lending Rate and LIBOR index will
change at different rates.

Some lenders use the LIBOR rate because it reflects their cost
of capital. Other lenders use the Prime Lending Rate because PRIME +
0.0% sounds better to consumers than LIBOR + 2.80% even when the rates
are the same.

Current Index Rates

Current LIBOR and Prime Lending rates can be found in the Federal Reserve's Statistical Release.
The LIBOR rate appears in the London Eurodollar Deposits lines (1, 3
and 6 month figures) and the Prime
Lending Rate appears in the Bank Prime Loan line.

The current (weekly) interest rates are:

Prime Lending Rate: 3.25%

LIBOR (1 month): 0.29%

LIBOR (3 months): 0.42%

91-day T-Bill: 0.09%

Spread between PRIME and LIBOR

The Prime Lending Rate tends to be 2.5% to 3.5% higher than the LIBOR
rate and 2.8% to 4.0% higher than the 91-day T-Bill. For example, the
3 month LIBOR for July 1, 2005 through September 30, 2005 was 3.38%,
while the Prime Lending rate was 6.00%. The difference between the two
indices was 2.62%.

The current spread between the Prime Lending Rate and the 3-month
LIBOR is 2.83%.
The current spread between the Prime Lending Rate and the 1-month
LIBOR is 2.96%.

The LIBOR rate tends to be slightly above the 91-day T-Bill rate and
to track changes in the 91-day T-Bill rate and federal funds
rate. However, during the subprime credit crisis of 2007 and 2008, the
LIBOR index was sustained at higher levels than before because of
turmoil in the asset-backed securitization (ABS) markets.

The Prime Lending Rate tends to be somewhat more volatile than the
LIBOR rate. The general trend with the Prime Lending Rate is to lag
decreases in bank cost of capital but to immediately reflect increases.
However, private student loans that are pegged to the 3-month LIBOR
will take an additional two months to catch up to changes in the
index.

Historically, the spread between the Prime Lending Rate and LIBOR has been
increasing,
meaning that over the long term a loan with interest rates based on
LIBOR will be less expensive than a loan based on the Prime Lending Rate.
A variable rate loan
pegged to the LIBOR index will grow more slowly than a loan pegged to
the Prime Lending Rate.

The following chart illustrates the spread between the Prime Lending
Rate and the 1-month and 3-month LIBOR indexes since 1971. As is
evident from the chart, the spread has been growing over time. It has
been relatively stable for the 15-year period from 1992 to
2007. (Volatility has also been decreasing.) Even
so, there is a slight advantage for loans pegged to LIBOR.
For example, consider a loan originated in January 1997 at LIBOR +
2.8% (8.24%) vs PRIME (8.25%). The average monthly rate for PRIME over
the ten year period from 1997 to 2006 would have been 6.82%, compared
with 6.77% for one pegged to the 3 month LIBOR. There's less of a
difference if the variable rate is pegged to the 1 month LIBOR.

Historial data is not necessarily predictive of future movement in
interest rates. Since the typical private student loan has a repayment
term of 20 or 25 years and a somewhat shorter average life, the
borrower must make a bet on which interest rate will grow more
slowly.

Competitive pressure will increasingly lead to long-term stability in the spread
between PRIME and LIBOR. The cost of capital for most major lenders is
similar, leading to similar consumer interest rates. Since most
lenders publish the interest rates they charge, there is
little reason for one major lender to undercut the others on price,
since they know that the others will quickly match rates. Any
advantage will be short-lived. Aside from branding, marketing and
other secondary factors, debt functions like a commodity. Money is
fungible; it doesn't matter much who the lender is, so long as the
loan can be used to pay the bills.

Smaller fringe lenders sometimes try undercutting the larger lenders, but
this does not have much of an impact on the Prime lending rate for
several reasons. First, the smaller lenders by definition have little
market share and so don't have much of an impact on the overall
average. Second, the economy of scale favors the larger lenders, who
are able to reduce their cost of capital by securitizing more
frequently. The larger lenders could easily afford to undercut the
smaller lenders to drive them out of business if they considered the
smaller lenders to be a threat. But they don't cut rates because
there's no upside to their cutting rates. Smaller lenders can compensate for
lower per-loan profits by increasing market share; larger lenders
can't. However, if
a smaller lender is successful in growing by cutting rates, they will
eventually feel pressure to increase profits and will gradually
increase interest rates on new loans.

So while there may be short-term influences that monentarily affect
the spread between PRIME and LIBOR, long-term the spread will be
increasingly stable.

Advice for Borrowers

This leads to the following advice for prospective borrowers of
private student loans:

If the interest rate available from one lender is more than 25 bp
(0.25%) lower than the rates available from other lenders, use that
lender regardless of whether the loans are pegged to LIBOR or
PRIME. The spread between PRIME and LIBOR is unlikely to vary by more
than that amount long-term.

But be sure that the difference is real. Focus on the actual interest
rate and not the advertised "as low as" rate. Beware of teaser rates
that mask a higher interest rate later on. Also be careful to factor
in the impact of higher fees on the cost of the loan. But be careful
comparing loans based on APR, as APR is not a good tool for comparing
loans that have different loan terms. (All else being equal, the APR
will be lower on a 25 year loan as compared with a 20 year loan.)

If the difference in interest rates is less than 25 bp, prefer
the loan that is pegged to the LIBOR index.

Of course, borrowers who are eligible for federal education loans
should exhaust their federal loan eligibility before resorting to
private student loans, as the federal loans are generally less
expensive. (There are a few exceptions where private student loans
offered by nonprofit state loan agencies are less expensive, but
private student loans offered by commercial lenders are generally much
more expensive than federal loans. For example, the average interest
rate on private student loans in 2007 was about 2% higher than the
Federal PLUS loan interest rate and about 4% higher than the Federal
Stafford loan interest rate.)